Suppose you have $10,000 of savings earning 0% interest and $10,000 of credit card debt costing 10% interest. Your net worth is zero, since $10,000 of assets minus $10,000 of liabilities equals zero, Smith explains. Each month, your net worth erodes further as you accrue interest on your debt faster than you earn it on your savings. The annual interest cost of your credit card debt is $1,000.
By immediately using the $10,000 in savings to pay off the $10,000 of debt, your net worth remains the same but you stop losing money, Smith says.
You may not have $10,000 sitting around to pay off your debt, but this example still shows why it makes sense to put your extra cash toward debt instead of savings.
If your debt isn’t consumer debt, the analysis changes somewhat, and not only because the loan may have a low rate and tax-deductible interest.
"Paying down a traditional loan like a mortgage or student loan only reduces the outstanding principal and related interest costs," Smith says.
Making extra payments will save you money in the long run, but in the short term, it doesn’t cause your lender to recalculate and lower your monthly payments.
Furthermore, Smith says, if you later have "buyer’s remorse" after paying off a significant amount of such debt, unlike a line of credit, you can’t borrow that money again without refinancing the debt and potentially incurring significant closing costs.
When deciding whether to pay off tax-deductible debt versus saving, don’t worry about losing a tax deduction if you pay off the debt. The deduction is probably worth less than the annual interest you would have paid on the loan.
Further, your goal should be to improve your overall financial condition, not to maximize tax write-offs, Smith says.
Saving before paying debt
There are a number of good reasons to save first and pay later, but the No. 1 reason is to build your emergency fund, experts say.
If your debt has a very low interest rate, it may make sense to save first, says Melissa Joy, CFP professional, partner and director of wealth management at the Center for Financial Planning, an independent registered investment advisory firm in Southfield, Michigan.
"If you don’t have any savings, focusing solely on paying debt can backfire when unexpected needs or costs come up. You might need to borrow again, and debt can become a revolving door," she says.
There are a number of good reasons to save first and pay later, but the No. 1 reason is to build your emergency fund.
Randall Greene, an investment adviser representative and CEO of Greene Financial Management in Altadena, California, suggests creating a mini emergency fund of $1,000 to $2,000 to cover typical emergency expenses to start.
In the long run, experts recommend building an emergency fund of 3 to 6 months’ worth of expenses, depending on how risky your income is. But, Greene says, it makes sense to increase your debt payments, starting with high-interest credit card debt, once you have your mini emergency fund in place.
Another situation where it makes sense to save before paying debt is when you’re talking about retirement savings, especially if there’s an employer match available.
"You should try to at least contribute enough to your retirement plan to receive your employer match. That’s guaranteed money that you don’t want to miss out on," Greene says.
In addition, "Putting off saving for retirement until you are debt-free could cost you your most valuable asset: time," Greene says. "Thanks to compounding, even small contributions to your retirement plan can grow significantly."
Best of both worlds?
Perhaps the best solution is to strike a balance between the two.
"Making contemporary goals of saving and paying down debt is what I recommend to most of my clients," Joy says. Both improve your overall financial picture.
You might be paying more interest than you need to, but having savings to cover sudden expenses like car repairs keeps you out of the debt cycle.
In addition, having sufficient savings provides peace of mind, Smith says. Some people are unlikely to feel at ease with any strategy, no matter how financially logical, that causes their savings to fall below a level that feels right to them. For these people, saving and paying down debt at the same time might be the best approach.
Neither extreme is likely to turn out well if it gives you considerable anxiety that prevents you from sticking to your plan, Smith says.